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The Changing Dynamics of Real Estate Investment

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By Mark L. Stockton

In today’s recovering residential real estate market, investors have played an important role, accounting for more than 20 percent of all purchases in recent months. As noted in an article that appeared on RISMedia.com on August 28, titled, “A New Breed of Real Estate Investor; The Value Investor,” there’s been a noticeable shift in the motivation of investors from those seeking deep discounts to those seeking sound investments in stable markets to hold for longer terms. This change in strategy signals an increasing need for good analytical tools to help investors make prudent decisions.

The abundance of properties that can be purchased for deep discounts has dwindled, which means proper evaluation of home values has gained importance as inventories have declined. As the anticipated holding period of the investments increases, the need to be able to evaluate the stability of individual markets takes on greater significance.

For example, a resident of Riverside, Calif., recently lost her home. She purchased it in May 2005 for $305,000, and at the time, the price was reasonable when compared to other homes in the immediate area. While I haven’t seen the appraisal that was done at purchase, I cannot deny that a reasonable appraised value for the property in May 2005 would have been approximately $305,000. What I can say with authority is that the appraised value at the time of purchase was unsustainable.

There are meaningful relationships in real estate markets just as there are in other markets (stocks, commodities, etc.) that must be monitored to support prudent lending and investing decisions. For example, we know there’s a relationship between rents and sale prices that should be considered—especially from the investor’s standpoint.

Another important relationship that’s been long overlooked that will help us understand the sustainability of property values is the relationship between the market value of a home and its depreciated replacement cost (RCNLD). There’s an old (often forgotten) adage that no prudent buyer would pay substantially more for a home than the cost to rebuild it on a similar site. This concept was once recognized by the appraisal industry and acknowledged in the cost approach to value. There was a time, not long ago, when appraisers had to provide commentary to support any cost approach in which the site value represented an excessive portion of the overall value. It was recognized at the time that a large disparity between the value of the improvements (depreciated replacement value) and the value conclusion (the market estimate derived from the cost approach) could be indicative of an unsustainable market value.

History has, in fact, shown us that when the gap between RCNLD and sale price begins to exceed its previous high in any given market, values are approaching unsustainable levels and we can be relatively certain that a correction in home prices is imminent.

When this individual purchased her house in 2005, the ratio between RCNLD and home prices (Market Experience Ratio©, or MER©) in the immediate area was in excess of 220 percent, meaning homes were selling for considerably more than twice their depreciated replacement costs. Her home and the neighboring homes were being sold very near the high point of what would become known as the housing bubble. For those of us who watch relationships closely and have developed a means of monitoring them on both a broad scale and granular basis, this was obvious. Each time this occurs, as it has on several occasions in the past 30 years, market prices respond by declining to a level that more closely approximates depreciated replacement cost. The current MER for homes in this area is averaging about 120 percent, and prices have reached reasonably sustainable levels for that locale.

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